Foundations of system-wide financial stress testing with heterogeneous institutions

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 15 May 2020

Staff Working Paper No. 861

By J Doyne Farmer, Alissa M Kleinnijenhuis, Paul Nahai-Williamson and Thom Wetzer 

We propose a structural framework for the development of system-wide financial stress tests with multiple interacting contagion, amplification channels and heterogeneous financial institutions. This framework conceptualises financial systems through the lens of five building blocks: financial institutions, contracts, markets, constraints, and behaviour. Using this framework, we implement a system-wide stress test for the European financial system. We obtain three key findings. First, the financial system may be stable or unstable for a given microprudential stress test outcome, depending on the system’s shock-amplifying tendency. Second, the ‘usability’ of banks’ capital buffers (the willingness of banks to use buffers to absorb losses) is of great consequence to systemic resilience. Third, there is a risk that the size of capital buffers needed to limit systemic risk could be severely underestimated if calibrated in the absence of system-wide approaches.

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